The technology, benefits, risks and regulatory measures you need to know about ICOs now

Organizations have raised more than $1.8 billion through initial coin offerings (ICO) since January 2017. For the first time, this June, Blockchain entrepreneurs raised more money through ICO than traditional venture capital investment. If you haven’t heard of ICOs, it’s the new fundraising phenomenon that has caught almost every investor’s attention.

An ICO, also called a token sale, token generation event or initial token offering, is an event in which an organization sells digital tokens for the purpose of obtaining public capital to fund software development, business operations, business development, community management or other initiatives. Tokens are cryptographically secured digital representations of a set of rights. Depending on the token, this could include the right to access and use a network or software application, the right to redeem the token for a unit of currency or a good, the right to receive a share of future earnings, the right to vote on decisions made by the organization or more.

As organizations continue to raise tens, sometimes hundreds, of millions of dollars in ICOs, it grows increasingly important for industry leaders and policymakers to understand the ICO economic and regulatory landscape and the technical lingo of the cryptocurrency and ICO space. There are concerns that the lack of regulation and control around this form of fundraising is risky for consumers, especially as the ICO model begins to attract mainstream retail investors.

The Stellar Development Foundation and The Luxembourg House of Financial Technology Foundation spent the last two months researching ICOs, speaking with developers, regulators, lawyers and entrepreneurs to get the most holistic view of the ICO phenomenon. If you want to know the ins and outs of ICOs, including the ICO lifecycle, an extended list of risks and benefits, use cases, how to launch an ICO, forecasted regulatory actions and recent global regulatory developments, check out our white paper. Our goal with this research is to advance discussion regarding how to use and regulate ICOs in a manner that will promote innovation while mitigating regulatory risk.

Here’s the highlight reel of our research:

The benefits of ICOs

ICOs have the potential to be a powerful force in the development of open-source blockchain technologies. ICOs could also prove to be a significant driver for financial access and inclusion by democratizing access to investments. ICOs are popular for multiple reasons.

For organizations who issue tokens:

Positive network effects. The ICO model generates positive network effects that can vitalize and strengthen decentralized applications that require numerous users (or operational nodes). Decentralized applications often feature significant network effects wherein the user experience for each user improves upon the inclusion of additional users. When an organization conducts a public and open ICO for the development of a decentralized application, the process can automatically generate a large user base that can sustain the operation, security and vitality of the decentralized network. If the users are token holders, they will be invested in the growth and success of the network.

Fast and easy fundraising mechanism. Anyone can initiate an ICO. Customized tokens can be easily generated through a number of platforms, including Ethereum, Stellar, Omni, NXT, Waves, Counterparty, Bitshares and RSK. Transaction costs associated with marketing and contribution settlement are significantly lower than traditional fundraising mechanisms.

Primarily online marketing. Tokens can be marketed over the internet to a large, general audience. Potential buyers can learn about the ICO through the organization’s website, online forums, online messaging applications, social media websites and more.

Liquidity. Popular tokens have liquid markets on cryptocurrency exchanges. The most popular tokens could exceed over $100 million in 24-hour volume.

Democratizing investment. Venture financing tends to be geographically concentrated in financial hubs like Silicon Valley, New York City and London. The ICO method generally allows anyone in any geography to raise money. It also generally permits anyone to contribute.

Potential for gains. Cryptocurrencies can appreciate quickly in price. Ether traded in August 2015 for under $1 and was trading at around $250-$350 in early September 2017. The price of bitcoin was around $100 in June 2013 and was trading at $4,000-5,000 in early September 2017. Investors hope to find a token that can be “the next bitcoin” in terms of economic appreciation.

The risk of ICOs

Consumer protection:

Lack of due diligence. There is no formal process to audit ICO organizations. Many teams conduct token sales before making significant progress in building out a functional product. The team may document their technology and business plans in a white paper, but there may be little evidence that the technology can be built as specified or that the business will operate as expected. Flaws in certain technologies may not be discovered until significant amounts of money have already been invested. Moreover, some organizations have a clause in their ICO terms that require contributors to accept the risk of project abandonment.

Uncertain basis for token valuation. Token prices may not be based upon their fundamental value. Many buyers may be buying tokens for investment purposes on the expectation that market prices will increase. Therefore, they may value a token primarily based on expected resale profits instead of the underlying economic utility. This may perpetuate bubbles and Ponzi schemes wherein older investors obtain trading gains primarily through the capital inflow of newer investors, rather than from legitimate increases in the fundamental utility of the token.

Market risks:

Extreme price volatility. The prices of tokens are highly volatile. For example, in the week ending September 3, 2017, 41 out of the largest 100 cryptocurrencies (by market capitalization) had a 7-day price change of greater than 5 percent. The price changes ranged from an increase of 405.29 percent (NAV token) to a decrease of 54.12 percent (ICO token). High-price volatility translates to high risk for token investors and could be a reflection of underlying market manipulation.

Market manipulation. The market for tokens could be manipulated in multiple ways. Some possible ways include pumping and dumping, spoofing, front-running and manipulative practices from “whales.”

General regulatory compliance:

Anonymous or pseudonymous token buyers. Token buyers cannot be easily identified because tokens are sent to and from cryptographic addresses. These cryptographic addresses could be traced to a particular individual, but some blockchains purposefully obfuscate transaction tracing for privacy purposes. Know-your-customer requirements associated with anti-money-laundering and countering the risk of terrorism regulations become more difficult to implement. On the other hand, some platforms enable organizations to require and share personally identifying information when making a transaction (e.g. Stellar). The organization can choose whether or not they wish to enforce KYC requirements.

Anti-money laundering (AML): There is increasing concern that ICOs could be used to finance terrorist organizations or to launder criminally derived money and reintroduce it into the system. Since cryptographically generated addresses can hide the identity of the parties, token transactions could make it difficult to identify the true parties to a transaction. Criminal parties could also use privacy-focused cryptocurrencies to obfuscate public ledger transactions.

Legality of ICO may differ depending on your state. Each of the 50 U.S. states may have a different regulatory approach toward cryptocurrencies. Some states, such as New York, require a license to operate certain cryptocurrency-related businesses. On July 19, 2017, the Uniform Law Commission approved the Uniform Regulation of Virtual Currency Business Act to be used as a model law for states seeking to adopt regulations for cryptocurrency businesses. The goal of the act is to create a harmonized regulatory schema for all 50 states and have reciprocity amongst states for cryptocurrency business licenses. The U.S. Securities and Exchange Commission has stated that some tokens may be considered securities, but has not provided clear guidance on the legality of different types of tokens. The U.S. Financial Crimes Enforcement Network (FinCEN) and Commodity Futures Trading Commission (CFTC) have not yet made a statement on the legality of ICO mechanisms. On July 27, 2017, FinCEN assessed civil monetary penalties against a foreign located cryptocurrency exchange (BTC-e) for violating US anti-money-laundering laws.

American flags hang at the United States Capitol, in preparation for President Obama’s second term inauguration ceremony in Washington, DC. (Photo by Brooks Kraft LLC/Corbis via Getty Images)

Beneficial regulatory measures

Regulations should not become an unreasonable burden for beneficial blockchain innovation. However, certain minimal regulatory measures could help to limit AML and consumer protection risks:

Assessment matrix. Governments should develop an assessment matrix for ICOs that: (1) identifies regulatory areas where ICOs may need to be compliant, (2) defines different token types and ICO structures and (3) specifies different legal standards and implications for different token types and ICO structures. This matrix would help to clarify the legal and regulatory jurisdictions and frameworks that would be applicable to the ICO.

Collaboration and reciprocity. Governments should collaborate with jurisdictions around the world to harmonize AML and investor and consumer protection requirements so there is a lower regulatory burden for organizations that operate globally. Collaboration would help to ensure that global consumers and investors have a baseline standard of protection, and that ICOs that are flagged as threats will be swiftly acted upon in all jurisdictions.

Regulatory sandbox. Authorities can help ICO organizations comply with regulatory compliance requirements by providing a “regulatory sandbox” environment in which authorities can temporarily relax certain regulatory requirements while the organization is testing and scaling its business model. In the sandbox, authorities can actively monitor the organization’s operations and provide swift feedback. This would provide regulatory certainty for ICO organizations, and it would help authorities track ICO activity.

A view of the Securities and Exchange Commission headquarters May 3, 2013 in Washington, DC. (Photo: BRENDAN SMIALOWSKI/AFP/Getty Images)

Future trends

In the U.S., more and more organizations are considering issuing tokens under the presumption that they are considered securities. These organizations are exploring issuing tokens under securities exemptions such as Regulation A+, Regulation D and Regulation S in the U.S. The U.S. cryptocurrency community is still waiting on a more definitive statement from the SEC, FinCEN and CFTC on regulatory requirements for ICOs.

On the consumer end, token buyers are becoming more cautious about buying and trading ICO tokens. The cryptocurrency community is launching efforts to self-regulate token sales and conduct due diligence on behalf of the public. For example, industry leaders have begun to draft public, crowd-sourced ICO evaluation and due diligence frameworks. Additionally, an organization called the ICO Governance Foundation was launched to establish best practices and standards for ICOs, starting by providing and maintaining a public filing and registration protocol. In the past few months, many bloggers have published articles that teach the public how to evaluate token sales.

There are multiple benefits and risks to ICOs. Despite movement in the regulatory space, the technology community sees strong potential in blockchain technologies, and there is strong demand for tokens. We hope regulators can structure flexible requirements that reduce risks while accommodating innovation in this young but burgeoning industry. We also hope that industry executives can explore and leverage blockchain technology for applications in their respective industries.

Related Articles

ShareTweetBitcoin created a lot of buzz on the Internet. It was ridiculed, it was attacked, and eventually it was accepted and became a part of our lives. However, Bitcoin is not alone. At this moment, there are over 700 AltCoin implementations, which use similar principles of CryptoCurrency. So, what do you need to create something […]

ShareTweetMarketing Strategy is a thought and planning to communicate and redeem a valuable offer for customers, partners, and the general public. It is very important to build a trustworthy presence and aim to adopt a wider market and introduce in new market segments. In relation to the crypto currents that many people are talking about […]

ShareTweetBitcoin is a virtual currency created by Satoshi Nakamoto in 2009 and used to conduct online transactions and can be sent via the Internet to anyone with an address. Although it still has many advantages and disadvantages, this type of currency is increasingly sought and discussed by virtual world workers because it can provide a […]